Whether crypto-assets will become a broad, investible asset class is more a question of “when” than “if”. Mostly, it will depend on how regulations for crypto-assets develop.
Regulation of crypto-assets is still at its infancy with various standard-setting bodies (SSBs) mostly at the stage of assessing risks associated with crypto-assets and providing advice to legislators to consider more in-depth rules in this area.
In some jurisdictions, such as in the European Union (EU) and the United States, regulation has been put in place to require crypto-exchanges to meet the same anti-money laundering (AML) and counter-financing of terrorism standards as are met by other financial institutions. In due course, other types of rules associated with crypto-assets are likely to be forthcoming.
In the EU, for example, the European Supervisory Authorities (ESAs) have just published advice to the European Commission this month spelling out next steps for the consideration of regulation of crypto-assets.
Different Types of Crypto-Assets
The ESAs have defined crypto-assets as a type of private asset that depends primarily on cryptography and Distributed Ledger Technology (DLT). These assets fall into the following ambit of financial services regulation: financial instruments (i.e., securities), electronic money, or neither of the above.
Presently, there is no common taxonomy in use by international SSBs for the different types of crypto-assets. That being said, some of the EU legislators are utilizing a basic taxonomy comprising of three main categories of crypto-asset. The European Banking Authority (EBA) provides the following definitions in its “Report with advice for the European Commission on crypto-assets.”
- Payment/exchange/currency tokens — So-called virtual currency or crypto-currency. These assets typically do not provide rights (as is the case for investment or utility tokens) but are used as a means of exchange (e.g. to enable the buying or selling of a good provided by someone other than the issuer of the token) or for investment purposes, or for the storage of value. Examples include Bitcoin and Litecoin. And “Stablecoins” are a relatively new form of payment/exchange token that are typically asset-backed (by physical collateral or crypto-assets) or are in the form of an algorithmic stablecoin (with algorithms being used as a way to stabilize volatility in the value of the token).
- Investment tokens — These typically provide rights (i.e., in the form of ownership rights and/or entitlements similar to dividends). In the context of capital raising, for example, asset tokens may be issued in the context of an Initial Coin Offering (ICO) which allows businesses to raise capital for their projects by issuing digital tokens in exchange for fiat money or other crypto-assets. An example is Bankera.
- Utility tokens — These typically enable access to a specific product or service often provided using a DLT platform but are not accepted as a means of payment for other products or services. For example, in the context of cloud services, a token may be issued to facilitate access.
According to the European Securities and Markets Authority’s (ESMA) report “Advice: Initial Coin Offerings and Crypto-assets,” hundreds of crypto-assets have been issued since Bitcoin was first launched in 2009. ESMA said “there are more than 2,050 crypto-assets outstanding, representing a total market capitalisation of around EUR 110 billion as of end-December 2018 — down from a peak of over EUR 700 billion in January 2018. Bitcoin represents just over half of the total reported value of market capitalisation, with the top five crypto-assets representing around 75% of the reported market capitalisation.”
Challenges for the Regulators
The legislators have said that crypto-assets do not yet pose a threat to financial stability, although they are all maintaining a watching brief on developments. The challenge for regulators, of course, will be to get the balance of regulation right by fostering innovation while at the same time garnering investor protection and market integrity.
There is a lot of detail for regulators to consider regarding which of the many existing regulations will need to be amended to take into account crypto-assets. Legislators will also have to decide whether to make new rules for the types of crypto-assets that are not in the scope of e-money or financial instruments regulations.
Regulators also will need to carry out continuous monitoring of innovation and may have to police the regulatory perimeter with respect to crypto-assets.
Another challenge for legislators is to attempt to maintain a level playing field with regards to the approach to regulation for crypto-assets across jurisdictions.
Consideration for Firms
The markets for these assets are likely to remain thin, however, until institutional investors such as pension funds allocate a percentage of their assets to the crypto-asset asset class.
More substantial growth and liquidity in this asset class is likely to become prevalent once regulation is in place and investors are conferred with the protections to which they are accustomed.
Both issuers of and investors in crypto-assets are likely to welcome globally-coordinated approaches to regulation in in this area. Appropriate regulation will allow those involved to ensure they are “playing by the rules” and thus the crypto-asset asset class will have more of a chance of becoming a better-regarded and more investible asset class.
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